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Concept Version 5
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How Taxes Impact Efficiency: Deadweight Losses

In economics, deadweight loss is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal.

Learning Objective

  • Discuss how taxes create deadweight loss


Key Points

    • Causes of deadweight loss can include actions that prevent the market from achieving an equilibrium clearing condition and include taxes.
    • Deadweight loss can generally be referenced as a loss of surplus to either the consumer, producer, or both.
    • Harberger's triangle refers to the deadweight loss associated with government intervention in a perfect market.

Terms

  • Pareto optimal

    Describing a situation in which the profit of one party cannot be increased without reducing the profit of another.

  • deadweight loss

    A loss of economic efficiency that can occur when an equilibrium is not Pareto optimal.


Full Text

Deadweight Loss

In economics, a deadweight loss (also known as excess burden or allocative inefficiency) is a loss of economic efficiency that can occur when equilibrium for a good or service is not Pareto optimal (resource allocation where it is impossible to make any one individual better off without making at least one individual worse off). Causes of deadweight loss can include actions that prevent the market from achieving an equilibrium clearing condition (where supply and demand are equal) and include taxes or subsidies and binding price ceilings or floors (including minimum wages). Deadweight loss can generally be referenced as a loss of surplus to either the consumer, producer, or both.

Harberger's Triangle, Taxes, and Deadweight Loss

Harberger's triangle, generally attributed to Arnold Harberger, refers to the deadweight loss (as measured on a supply and demand graph) associated with government intervention in a perfect market . This can happen through price floors, caps, taxes, tariffs, or quotas. In the case of a tax on the supplier of a good, the supply curve will shift inward in proportion to the tax and resulting in a non-market clearing level of supply. As a result, the price of the good increases and the quantity available decreases .

Taxation and Deadweight Loss

Taxation can be evaluated as a non-market cost. In this case imposition of taxes reduces supply, resulting in the creation of deadweight loss (triangle bounded by the demand curve and the vertical line representing the after-tax quantity supplied), similar to a binding constraint.

Harberger's Triangle

Deadweight loss, represented by Harberger's triangle, is the yellow triangle. It represents lost efficiency.

The area represented by the Harberger's triangle results from the intersection of the supply and demand curves above market equilibrium resulting in a reduction in consumer surplus and producer surplus relative to their value before the imposition of the tax. The loss of the surplus, not recouped by tax revenues, is deadweight loss.

Some economists have argued that these triangles do not have a huge impact on the economy, whereas others maintain that they can seriously affect long term economic trends by pivoting the trend downwards, causing a magnification of losses in the long run.

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